Flat rate method vs Reducing Balance method

For those of you who are looking for a loan in the near future, whether it is an auto loan, home loan or personal loan, one important thing to keep in mind is the type of interest rate you choose. There are two types of rates which can be applied to loans known as the flat rate and the reducing rate.

It is important to understand the difference between the two in order to make accurate comparisons.

 

Flat rate method:

 

A Flat rate of interest means the amount of interest paid is fixed. In this method, the amount of interest is calculated on the original loan amount throughout its tenure, thus interest remains constant and does not reduce as the principle amount decreases with your monthly EMI. This method is particularly used to calculate the interest payable for personal loans and vehicle loans.

 

Interest Payable per Installment = (Original Loan Amount * No. of Years * Interest Rate p.a.) / Number of Installments

 

Take example of a five year loan with principle amount of Rs. 100,000 at a flat interest rate of 10%.

 

Your annual interest is always calculated as 10% of 100,000. Thus, your annual interest payment is fixed at Rs. 10,000. Total interest over the five year period would become Rs. 50,000.

Total amount paid for the loan duration = 100,000+50,000 = 150,000

Annual installment (Total amount/ Number of years) = Rs. 30,000

Monthly EMI = Rs. 2,500

 

Reducing Balance Method:

 

In reducing balance method, the interest to be paid is revised every month on the outstanding loan amount. In this method, the EMI includes interest payable for the outstanding loan in addition to the principal repayment. Now, since principle amount reduces with every EMI payment, the amount of interest payable on it also reduces. Thus, on subsequent EMI payments, the amount towards principle repayment increases. This method is particularly used to calculate the interest payable for housing, mortgage, property loans, overdraft facilities, and credit cards.

 

Interest Payable per Installment = Interest Rate per Installment * Remaining Loan Amount

 

It is obvious that at same rates,, the interest payable as per reducing balance method would be less as compared to interest payable as per Flat rate method.

 

Take the same example of a five year loan with principle amount of Rs. 100,000 now at reducing balance interest rate of 10%.

 

The actual calculations are quite tricky. But, we have tabled out a brief summary of repayments as follows:

Year	Outstanding Balance	Principal Paid	Interest paid	Yearly payment
0	100,000
1	83,620	16,380	10,000	26,380
2	65,603	18,018	8,362	26,380
3	45,783	19,819	6,561	26,380
4	23,982	21,801	4,579	26,380
5	0	23,982	2,398	26,380
Total payments		100,000	31,900	131, 900

We see by Reducing balance method, the yearly installment comes out to be Rs. 26,380

Thus, Monthly EMI = Rs. 2198. Over the entire duration, you pay 1.31 lacs as compared to 1.5 lacs.

 

Further calculations show that an interest amount of 50,000 using reducing balance method is yielded at an interest rate of 17.27%.

Thus, for a five year loan of Rs. 100,000, 10% Flat interest rate = 17.27% Reducing balance interest rate.

Read – Prepaying the Home loan or Investing your savings- What to do

Here is a brief of the Differences between Flat Interest Rate and Reducing Balance Rate:

 

• In flat rate method, the interest rate is calculated on the original principal amount of the loan. On the other hand in reducing balance method, the interest rate is calculated only on the outstanding loan amount on a monthly basis.
• Flat interest rates are generally lower than the reducing balance rate as charged by the bank.
• Calculating flat interest rate is easier as compared to reducing balance rate in which the calculations are quite tricky.
• In practical terms, the reducing rate method is better than the flat rate method.

 

Conclusion:

 

The thing to understand is that banks offer low flat interest rate than reducing balance rate. But, cheaper rate may not necessarily be better. If a bank advertises a 8% flat rate while another bank advertises a 12% reducing rate, the reducing rate is actually cheaper!

The best way of comparing is by converting everything into equivalent rate and compare equivalent monthly installment (EMI) keeping tenure fixed.

 

Ask the bank, what your EMI would amount to be. Cheaper EMI over the same time period means cheaper loan.